In 2004, the Nobel Committee awarded Finn E. Kydland and Edward E. Prescott the Nobel Prize in economics, citing their contribution to “dynamic macroeconomics: the time consistency of economic policy and the driving forces behind business cycles.” Kydland, the Henley Professor of Economics at the University of California at Santa Barbara, was in Washington, D.C., recently to present a seminar at the IMF Institute. He spoke with Arvind Subramanian, Division Chief in the IMF’s Research Department, about receiving the Nobel Prize and the implications of his work for the economics profession.
Subramanian:What were you doing when the famous call came from the Nobel Committee?
Kydland: I was in Norway teaching dynamic macro at the basic MBA level. A secretary came in, saying that there was a call for me. I wanted to wait five minutes until the break, but she said, “No. No. They are quite insistent.” When I answered the phone, there was someone speaking to me in Swedish. The head of the Nobel Committee read what seemed to be a prepared statement and said, “Just so you don’t think this is a joke, I have a couple of people here you know.” He then put them on the line.
Subramanian:There’s no question that your work on credibility and commitment has made a huge contribution to economics. But can credibility and commitment be overdone, as some say is the case with the European Union’s Stability and Growth Pact? In practice, don’t you need the right combination of flexibility and commitment?
Kydland: Well, there are two aspects. One is that whatever you commit to ought to be a good policy. It should not be commitment for its own sake, but commitment to something that benefits the people and the economy, and generates growth that is close to the highest possible rate. So, first, the choice of policy has to be wise, but then commitment is indeed extremely important.
Subramanian:How do you feel about charges that the Stability and Growth Pact is too much of a straitjacket, that there isn’t enough flexibility to adjust to cyclical variations?
Kydland: Well, that’s not so much criticism of a commitment mechanism as it is criticism of the policy to which Europe has tried to commit. And without having studied it in detail, it could very well be that there isn’t enough leeway in the ability to make the debt fluctuate over the business cycle. Economists understand that it’s better to make the debt fluctuate cyclically than make the tax rates fluctuate cyclically. So some leeway should be included, but not too little or too much.
Subramanian:Let me quote two illustrious economists on real business cycle theory—one of your two contributions cited by the Nobel Committee. First, “If recessions are a rational response to temporary setbacks in productivity, was the Great Depression really just an extended voluntary holiday?” And, second, “The theory of the real business cycle is like the Ptolemaic system that guided ships for centuries but was totally wrong.” The first quote is by Paul Krugman; the second is by Larry Summers. Your response?
Kydland: Our work created a framework for addressing interesting aggregate economic questions. It has become a standard framework. It’s true that our first paper focused on one particular source of business cycles— namely, shocks to productivity or aggregate production possibilities, which, if you interpret it broadly, can include lots of things. But since then, the same framework has been used to study other sources of business cycles, such as monetary shocks and taxes.
In spite of the currency board, Argentina didn’t have credibility among investors—perhaps because they had been burnt several times before.
Subramanian:The stress on microfoundations was very valuable, but people seem less convinced by your explanation that cyclical fluctuations were caused by fluctuations in productivity.
Kydland: They were less convinced and it’s less important. Though I must say that I haven’t seen anything that really overturns our finding that roughly two-thirds of the U.S. business cycle can be accounted for by fluctuations in productivity.
Subramanian:But is it fair to say that real business cycle theory is taken less seriously now—microfoundations apart?
Kydland: One thing we have learned is that business cycles are not that costly to people. The welfare implications are not that big—at least from normal business cycles. That’s not to say, of course, that governments can’t implement bad policies and make things much worse. But it may behoove us to devote more attention to longer-run questions where the benefits can be really great. As our understanding of economic theory improves and as computers improve, it is natural to turn our attention to things that matter over the life cycle, such as social security, immigration, age and wealth distribution, and so on.
Subramanian:What are your current research interests?
Kydland: One is country studies. I find it interesting to work on two quite diverse economies like Argentina and Ireland. Argentina followed very bad policies for decades. In my Nobel Lecture, I called it the time consistency disease. The surprising thing about Argentina is that once you put the numbers into a standard model, the model says that Argentina should have grown much faster in the 1990s. That suggests, for example, that in spite of the currency board, Argentina didn’ t have credibility among investors—perhaps because they had been burnt several times before. And Argentina today has substantially lower capital stock per working-age person than it had 20 years ago. It’s amazing, and very depressing.
Then you have Ireland, which has been an incredible success story. One can learn from that as well. Part of it probably has to do with the long-run aspects of the policy measures they put in place to encourage capital accumulation.
Subramanian: Aren’t there really two distinct things here? One is the need for countries to pursue credible policies for the future; the other is that countries are victims of their history. If you have a history of debt repudiation and expropriation, it’s really difficult to erase that. If you look at debt-to-GDP ratios in the developing world, India’s is very, very high, about 80-90 percent. But over the past few years, interest rates actually have been coming down, even though deficits and debt have been going up. One explanation is that India has less of a credibility problem; it does not have a history of repudiating debt, overtly or through inflation, and markets are willing to cut it more slack. People compare debt to GDP around the world, but one shouldn’t do it too mechanically, because it’s not just about the future, but also about the past.
Kydland: That’s a very good point. India is benefiting from the fact that its past governments haven’t done things similar to what past Argentine governments have done.
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